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Blurry Fiscal Hindsight

April 24, 2015 11:22 amApril 24, 2015 11:22 am

Simon Wren-Lewis continues his voice in the wilderness campaign against British economic myths, focusing on claims that Labour was fiscally profligate.
Needless to say, I agree, and would like to enlarge on his points.

The simple fact is that Britain was not running big deficits on the eve of the financial crisis, and that public debt wasn’t high by historical standards. So how does that record get turned into a claim of wildly
irresponsible budgeting? As Wren-Lewis says, there are really two levels to this diversion. First, there’s the highly questionable reinterpretation of past GDP data; second, there’s the implicit proposition
that governments in the past should have based fiscal policy on information (or actually “information”) that didn’t exist at the time.

On the first point: these days official estimates say that Britain, although it had a modest actual deficit in 2006-2007, had a large “structural” deficit. How so? Well, these estimates are now based on
estimates of potential output, which purport to show that the British economy in 2006-7 was hugely overheated and operating far above sustainable levels.

But nothing one saw at the time was consistent with this view. In particular, there was no sign of inflationary overheating. So why do the usual suspects claim that Britain had a large positive output gap?

The answer is that the statistical techniques used by most of the players here automatically reinterpret any prolonged slump as a slowdown in the growth of potential output — and because they also smooth out
potential output, the supposed fall in current potential propagates back into the past, making it seem as if the pre-crisis economy was wildly overheated.

As an extreme example, consider Greece. Here’s the IMF estimate of Greece’s output gap before the storm:

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Credit

Does anyone really believe that Greece was operating 10 percent — 10 percent! — above capacity in 2007-8? This is just a smoothing algorithm producing nonsense results in the face of economic catastrophe.

And this backward propagation of economic disaster also leads, automatically, to the appearance of past fiscal profligacy. Consider the case of Ireland. Back in 2006 George Osborne praised the country as a “shining example” of “wise economic policy-making”, and especially praised the country’s fiscal prudence. Today, backward-looking estimates say that Ireland was fiscally irresponsible
all along:

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Credit

Even if you believe these estimates (which you shouldn’t), it’s unfair to criticize the Irish government of the time for fiscal profligacy. They believed that they were acting responsibly, and all the
best people were praising them for it.

So were Blair and Brown irresponsible? No, not at all. True, if they had known the crisis was coming they would probably have tried to pay down debt during the good years. But they didn’t know that, and in any
case it’s hard to imagine that it would have made any significant difference. Claiming that there was a major failure of fiscal prudence isn’t even 20-20 hindsight, it’s hindsight with a severe
case of astigmatism.